Morningstar Study Reinforces the Importance of Fund Costs By John Spence February 27, 2002

Chicago fund-tracker Morningstar wrapped up a study that examines the importance of fund costs on an investor's bottom line. Although the study looked only at actively managed domestic equity funds, the results should provide further encouragement to cost-conscious indexers.

Morningstar took 629 funds and ranked them in quartiles by their 1996 expense ratios and looked at how the funds performed over the next five years. The funds were grouped according to Morningstar's style box, which pigeonholes a fund into one of nine asset classes according to style (growth, value, blend) and size (large, mid, small).

Morningstar found that in 8 of the 9 style boxes, the cheapest quartile performed significantly better over the five-year period than the most expensive quartile, with the exception being the small-blend arena. On the surface, these results shouldn't be too surprising. "In efficient and inefficient markets alike, all investors as a group share the market's returns before costs, and lose to the market in the exact amount of those costs," says Vanguard founder John Bogle.

Of course, some managers of high-cost funds were able to significantly outperform their peers, a point that has never been disputed even by hard-core indexers. The problem is that it's extremely difficult if not impossible to identify these managers in advance.

"It's inevitable that every year some stock pickers will beat the market. That's a matter of random events, otherwise known as luck," wrote Paul Merriman in a recent column.

Morningstar is not endorsing simply buying the lowest-cost fund in each category, but cheaper funds are generally more attractive because they have a head start over their more expensive counterparts.

"Buying low-cost stock funds is no guarantee that a fund will be a great catch, but it makes a lot of sense to fish in the low-cost pond," said Morningstar analyst Scott Cooley, who also noted that the results indirectly confirm the virtues of cheap index funds.

In another example of the danger of chasing recent performance, Cooley found that buying a poor-performing (over the previous 5 years) low-cost fund in 1996 was generally a better strategy than picking up a high-flying expensive fund. In other words, high-cost funds have a tough time sustaining big returns.

The reason for this difficulty is easily explained. To overcome the hurdle of higher expense ratios, fund managers must take on more risk to outperform their less expensive peers. Taking on more risk can naturally produce higher returns, but there is a greater chance that risk will bite back in the future.

Given the results of this latest study and countless others, it seems that a prudent strategy for fund investors with long time horizons is to look for low-cost funds that don't take on outsized risk and volatility. Sounds a lot like an index fund, doesn't it?